A Call for the Creation of
Socially Responsible Real Estate Investment Products[1]
By Gary Pivo, MRP, PhD[2]
Introduction
The purpose of this essay is
to suggest that it’s time to introduce real estate investment funds that are
managed according to principles of socially responsible investing. As explained below, there may well be an
enormous untapped market for such funds, which is estimated here to be on the
order of $6 to $15 billion.
The Case in Brief
Individual investors are
increasingly being advised to include real estate in their portfolios. It can
“enhance the portfolio’s returns while helping to diversify volatility and
risk.”[3] According to one study, an investor that put 10% of his/her money into publicly traded real
estate investment trusts in 1992 would
have had 7.5% more in his account by 2001, compared to those who stuck with
just stocks, bonds and cash.[4] A recent review of
the literature concluded that “real estate has a definite role in the
formation of efficient portfolios. There
are many works suggesting optimal allocations to real estate of approximately
10% to 20%.”[5]
But real estate isn’t a
socially or environmentally neutral commodity.
Depending on how a development is sited, designed, and subsequently
managed, the end result can either improve or harm the social and environmental
fabric of a community. For example, the
UN reports that inefficiencies in urban energy use, largely attributable to the
nature of urban development, are a primary cause of the rise in greenhouse gas
concentrations globally. Therefore, millions of socially responsible investors,
who make investment decisions based in part on their social and environmental
consequences, should have an interest in real estate funds that can “do good
while also doing well.” [6]
At the present time there are
few if any real options, aside from direct investment, for individuals
interested in socially responsible real estate (SRRE). Despite there being over 300 real estate
investment trusts, I have yet to identify a single one that makes social
responsibility or sustainability an explicit goal. In fact, REITs have a tendency to seek out
investments in the 19 standard real estate products, as a means of reducing
risk. This only replicates the
“conventional development” that tends to produce urban sprawl, auto-dependence,
urban decline and other problems.[7] One option is community development
investment funds. But they typically
spread their assets among low income housing, micro-lending, small business,
and community development and may only be open to institutional investors or
highly capitalized individuals. While there
is a variety of socially responsible mutual funds and a variety of conventional
real estate funds, so far there don’t appear to be any funds that merge the two
and offer investors a professionally managed socially responsible and progressive real estate
portfolio.
Possible Types of Funds
SRRE funds could take at
least four different forms.[8] One option could be publicly traded real
estate investment trusts whose stocks trade on the public securities
markets. These funds would acquire and
manage a portfolio of SRRE. Another option
would be private funds that are not traded on the public securities markets, which
would buy and sell properties that meet their SRRE criteria, and would be sold
to investors by the fund sponsors or securities brokers. A third form would be so-called funds of
funds, which acquire interests in multiple private funds. The minimum investments required to become a
member would be smaller than is normally required by private funds and the fund
managers would provide a service by selecting the private funds to be purchased. A fourth option would be real estate mutual
funds, which would buy and sell publicly traded REIT or development company
stocks that pass social and environmental screening.
A primer on socially
responsible investing
According to the Social Investment Forum (SIF),
“socially responsible investing is an investment process that considers the
social and environmental consequences of investments, both positive and
negative, within the context of rigorous financial analysis.”[9] It considers the “triple bottom line” by
which investments are evaluated in terms of their financial profitability,
social equity, and ecological integrity.
According to SIF, socially responsible investment
typically entails 3 strategies that work together to promote sound business
practices and societal improvements: Screening is the practice of including, excluding, or evaluating
investments on the basis of social and/or environmental criteria. Shareholder Advocacy entails
becoming involved as owners of corporate
In 2001, the mutual fund universe totaled about 7
trillion dollars.[10] In the same year, 2% of the universe, or $136
billion, were in socially screened mutual funds.[11]
Asset flows
indicate that investors are finding socially screened funds more attractive
than other funds. According to SIF,
screened funds attract and retain investor assets longer than non-screened
funds and socially responsible funds saw net inflows of
$1.5 billion during 2002 compared to a $10.5 billion outflow for
The Potential Market
for SRRE
As noted above, an optimal allocation to real estate
has been found to be 10 to 20 percent of a portfolio. If 10 to 20% of the approximately $150 billion
now in socially responsible mutual funds were allocated to SRRE funds, they
would contain $15 to $30 billion.
Alternatively, if 2% of the funds now in publicly traded real estate
investment trusts were moved to SRRE funds, matching the ratio of socially
screen mutual funds to all mutual funds, the total in SRRE funds would come to
over $6 billion.
Selecting SRRE Investments
A SRRE fund would use positive and negative screens to
help select its investments. Positive
screens would be used to emphasize smart growth and sustainable development
such as urban and suburban infill, mixed use projects, green architecture,
affordable housing, transit-oriented development, historic preservation,
conservation communities, new urbanism, and sustainable forestry. Negative screens would be used to avoid investments
that harm neighborhoods, fill wetlands, displace residents, discourage walking,
demolish historic structures or produce other adverse consequences.
Any one SRRE fund wouldn’t
necessarily invest in all types of real estate.
Research on real estate investment trusts, for example, recommends some
type of focused strategy.[12] Thus, a SRRE fund could choose to limit its
investments to a single type of property, such as multi-family housing. But a family of funds or a variety of
separate funds could cover all types of properties.
One of the questions raised
by the notion of screening is whether there would be enough opportunities to
choose from. For example, there are
currently only 137 LEED Certified projects, under the green building program
administered by the U.S. Green Building Council.[13] However, there are many thousands of
apartments and office buildings located within walking distance of public
transit stations, which is known to increase transit use and reduce driving
alone.[14] Additional research is required to determine
how coarse or fine to make the screens, but it should not be assumed that only
the most progressive projects or funds would be suitable for inclusion in SREE
portfolios. Indeed, most socially
responsible mutual funds only screen to avoid tobacco and alcohol related
companies[15] and so
SRRE funds would not have to be particularly restrictive to be in line with
normal industry practice.
Managing Properties:
“Doing good by Doing Well”
One of the basic strategies
followed by real estate funds is known as the value-added strategy in which
they use their property management skills to increase the value and returns of
under-performing properties.[16] This approach can apply to SRRE management by
using improvements in energy efficiency or water conservation, for example, to
conserve resources, reduce utility costs, and increase net operating
incomes. Moreover, many prospective
tenants may well place a premium on socially responsible buildings because of
their prestige, capacity to improve employee productivity, multi-modal
accessibility, and other possible benefits.
This should translate into higher rents and potentially better returns
for investors.
Economic Performance
Little is known about
the financial performance of socially responsible projects compared to
others. However, there is evidence that
suggests SRRE may be at least as profitable as conventional properties:
·
According to the 2003 Real Estate Performance Report by the
National Council of Real Estate Fiduciaries, the 240 central business district
office properties in their data base produced an average annual total return of
10.2% over the past 5 years, compared to 7.7% for 915 suburban properties. Downtown office buildings could easily be
classified as SRRE because they use less land, generate less driving
alone, and provide better access to jobs for lower income households. In addition, the same report shows that
high-rise apartments, which by virtue of their higher density help save land,
materials and energy, outperformed garden-apartments over the same 5 year
period.
·
Up until 2003,
The Woodlands was owned by Crescent Real Estate
Equities Company, one of the largest REITs.
The Woodlands emphasizes the preservation of the natural forest
environment and was designed by Ian McHarg, author of Design with Nature and one of the foremost landscape architects of
the 20th century. According
to Crescent, the company recognized over $200 million in funds from operations
(FFO) and received more than $310 million in gross cash distributions over the
approximate six-year life of their investment, which translated into a pre-tax
internal rate of return of 43%.
·
An
academic study assessed the impact of new urbanism on single family home
prices. It found that consumers were willing to pay 12% more for homes built in
the Kentlands, compared to similar homes in surrounding areas.[17] This demonstrates a consumer preference for
living in walkable communities.
·
A
recent book on infill housing, published by the Urban Land Institute, reached
the following conclusion: “Though
developers are quick to agree that it’s easier to build in greenfields and that
infill housing typically costs more to develop…they also agree that when infill
housing succeeds, the financial returns for lenders and equity investors are
greater over time.”[18]
Funding Smart Growth
Two recent papers
discuss the challenge of finding equity capital to support progressive real
estate development.[19] One of the problems is that it’s perceived as
being more risky. This leads to higher
required rates of return and pressure to produce cash flow quickly. The papers report a need for more patient
funding sources, such as foundations or pension funds that have lower
requirements on returns for their investments.
SRRE funds might also help address this problem because socially
responsible investors derive utility from knowing that their investments are
being managed in a socially responsible manner and are thus willing to accept
lower short term gains.[20]
Conclusion
With the current level of
interest in socially responsible investing and rapid growth in real estate
investment funds, it is remarkable that there is no such mechanism that offers
investors the opportunity to own socially responsible real estate. As demonstrated above, an extrapolation of
currently expressed preferences for socially responsible investment, when
applied to the real estate industry, suggests a market that is on the order of
6 to 30 billion dollars per year. Urban
development has serious implications for our social, environmental, and
personal health. Mounting evidence
suggests the need for a mechanism that at minimum enables, but ideally
facilitates and rationalizes, increased capital targeted at socially
responsible, progressive forms of development.